As a result of the market crash of 1929, the U.S. Federal Government enacted legislation aimed at protecting investors and requiring greater due diligence among professionals in the financial industries through passage of the 1934 Securities Exchange Act. This Act also led to the creation of the Securities and Exchange Commission (SEC) which creates and enforces rules and requirements for both individual investors as well as financial institutions in maintaining system integrity and providing “equal footing” for all participants. The SEC has further authorized industry associations, such as the National Association of Securities Dealers (NASD), which self-regulates its members. Currently, the NASD regulates over 5,300 brokerage firms and 664,000 representatives. As a result of both NASD and SEC rules and requirements, much greater protection and fiduciary responsibility has been put in place. One of the key contributing factors to the 1929 market crash was the highly leveraged financial position of many individuals based upon the recommendation of their financial advisor or broker. Unsuitable investments were often selected for these investors such as high-risk, high-volatile securities for retired individuals, living on a fixed income, with a limited asset base who did not understand the potential downside of such a highly leveraged position. Furthermore, leverage (commonly referred to as margin) positions enabled a small investment to control a much larger total investment by borrowing against the equity. In many cases, it was possible to control as much as 20 times the assets based on the investment. This highly leveraged strategy generated significant returns when the underlying asset appreciated, but it generated significant loses when the underlying asset depreciated. Once the stock market started to correct, it gained in speed and severity as investors had to sell assets. This further increased selling pressure causing a downward spiral in asset values. As a result, many individual investors found themselves with outstanding margin loans that they then had to repay. The 1934 Act was intended to remedy many of the underlying factors that contributed to the market crash. Stricter guidelines for margin accounts was implemented as well as placing greater responsibility on financial professionals to follow specific guidelines when soliciting or selling securities to individuals. These financial professionals were assigned a fiduciary responsibility to “know their customer” and offer only those securities that would meet the individual's financial objectives based on their income, asset base, knowledge, and experience in the markets. Financial professionals were further required to obtain specific licenses in order to practice in the industry to ensure a minimum level of understanding, training, and market knowledge.
During the 20th century, there was an unprecedented level of growth in the financial markets. Stock ownership continues to reach new levels of participation with many investors investing directly through individual, brokerage, and retirement accounts in addition to managed investments such as mutual funds or insurance policies. Advances in technology and changes in legislation have resulted in a changed landscape from when the 1934 Act was first implemented. During the 1980s, a new category of brokerages emerged, that of discount brokers. Online brokerage firms then followed in the 1990s with the widespread use of the Internet. As such, it has become increasingly more difficult for financial professionals to “know their customer” and fulfill their fiduciary responsibilities. However, despite the changed industry, the fiduciary responsibilities remain in place. Financial institutions and representatives are still responsible for monitoring the investment strategies and practices of their customers in order to comply with the 1934 Act. In some cases, failure by financial institutions and/or representatives to “know their customer” and allow suitable investments to be acquired by investors has led lawsuits costing this sector millions of dollars in fees, penalties, and goodwill. Given the ongoing growth and expansion of the financial services sector, the number and types of lawsuits will continue to rise unless more sophisticated tools are provided that will enable the proactive management and protection of financial institutions, representatives, and customers.